When countries across Europe were putting together austerity policies in 2011, the orthodox reasoning was that the debt and deficit of the nations were out of control, and that this was being communicated by the markets, in the form of bond yields.
But did nations actually base their estimates of the need for austerity on the fiscal fundamentals? Or were they misled by market reaction? A research paper from Paul De Grauwe and Yuemei Ji breaks down the question.
It's certainly the case that the austerity was based, almost entirely, on the state of the market. The authors compare the extent of austerity measures in 2011 with the spreads of the nations' bonds (the difference between each country’s 10-year government bond rate and the German 10-year government bond rate), and find a near-perfect correlation:
Austerity measures and spreads in 2011
The authors write:
There can be little doubt. Financial markets exerted different degrees of pressure on countries. By raising the spreads they forced some countries to engage in severe austerity programs. Other countries did not experience increases in spreads and as a result did not feel much urge to apply the austerity medicine.
Now, that in itself is not particularly problematic. After all, if the financial markets are rationally responding to problems in the respective nations' finances, then it makes sense to try and calm them by getting finances under control. But if the markets are instead in the throes of irrational panic, then basing policy around their whims is problematic.
Ji and de Grauwe then come up with two proxies to test what it actually was which was driving the financial markets. If the markets are acting rationally, then as fundamentals improve, the spreads should fall. So, starting in mid-2012, they compare the change in debt-to-GDP ratio (just one possible measure of fiscal health) to the change in spread values.
They find that, over the period they're examining, debt-to-GDP ratio increases in every one of the ten nations they study. Despite this, however, the spreads decrease in each — and those decreases aren't particularly correlated with the debt-to-GDP change:
Change in debt-to-GDP ratio vs. spreads since 2012Q2
The bond markets don't appear to pay much attention to the basic financial health of the nations. What they do pay attention to is the European Central Bank. The paper states that:
The decision by the ECB in 2012 to commit itself to unlimited support of the government bond markets was a game changer in the Eurozone. It had dramatic effects. By taking away the intense existential fears that the collapse of the Eurozone was imminent the ECB’s lender of last resort commitment pacified government bond markets and led to a strong decline in the spreads of the Eurozone countries.
In the summer of 2012, the ECB removed fear from the equation. What happened then was a widespread collapse in bond spreads. But the collapse wasn't uniform; instead, "countries whose spread had climbed the most prior to the ECB announcement experienced the strongest decline in their spreads". By taking away panic, the ECB lets us see that almost all of the prior variation in the bond spreads had been as a result of that panic.
Basing policy on calm sensible market reactions might work; basing it on the reaction of markets in existential fear probably wouldn't. That's traditionally the time when politicians start trying to lead markets, rather than follow them. And, sure enough, the authors repeat a calculation confirmed by many others: panic-driven austerity has crushed growth in the nations it's been practiced…
Austerity and GDP growth 2011-2012
…and has hurt fiscal fundamentals in those same nations, with debt-to-GDP ratios getting worse the more austerity is practiced:
Austerity and increases in debt-to-GDP ratios
The TUC's Duncan Weldon (whose tweets first pointed me to the research) sums up the lessons we've learned:
- Financial markets are perfectly capable of acting irrationally. Market panic drove extreme austerity in Southern Europe.
- Extreme austerity has proved self-defeating – it means debt/GDP ratios are higher not lower.
- Markets, to quote the IMF’s Chief Economist, can be ‘schizophrenic’ – they initially reward harsh austerity measures and then panic when they, predictably, lead to weaker growth.
- The end result is that market panic, followed by policy-maker panic, has imposed huge economic and social costs across Europe
Seems like if politicians really really want to base their decisions on the ill-thought-out panic of large numbers of people, they ought to at least wait for an election.